More From Glenn Ruffenach

MLPs have taken on the aura, seemingly, of an all-but-foolproof investment: a conservative play with great tax benefits and -- most important -- yields of 6 percent or more. With the 10-year Treasury offering yields of about 1.9 percent, it's no wonder I've been getting reader e-mails like this one: "I have been heavily invested in master limited partnerships for the past three years, and can't understand why everyone else, especially seniors like myself, is not. In my opinion, there is no better place for taxable money than in MLPs."

Okay, let's take off the rose-colored glasses.

It's easy to see why products like MLPs (or municipal bonds or preferred stock), which appear to offer sweet returns with little risk, can inspire drooling among retirees and pre-retirees hungry for steady income. But don't let a craving for cash flow keep you from exercising due diligence -- because foolproof, they're not.

First, a quick primer. MLPs are publicly traded companies that, for the most part, transport and store oil and natural gas (think: pipelines and holding tanks). A general partner runs the business, and the limited partners are investors. That structure results in two big benefits for holders: sizable payouts (an MLP doesn't pay corporate taxes, which means bigger distributions), and handsome tax breaks (distributions are considered a "return of capital," which means no taxes on most returns until the investor sells the MLP).

Perhaps the best reason to include MLPs among your holdings is their potential for growth. New methods of unlocking petroleum and natural gas from shale formations are pumping up energy production. One recent study from the Interstate Natural Gas Association of America projects spending of about $250 billion between now and 2035 to meet infrastructure needs. "That's a good story going forward," says Kevin McCarthy, head of Kayne Anderson Capital Advisors' four closed-end funds that invest in MLPs.

Indeed it is. So…what's not to like?

Gravity

MLPs are, in effect, stocks. And stocks can go down. Between July 2007 and December 2008, when the S&P 500-stock index fell 41 percent, master limited partnerships, as measured by the Wells Fargo MLP index, did even worse, dropping 49 percent.

Nest Eggs

Unfortunately, individual MLPs aren't suitable for retirement accounts. Uncle Sam thinks it's too much of a good thing to hold one tax-deferred product (an MLP) inside a second tax-deferred product (an IRA). If you do so, the Internal Revenue Service will have its hand out. (That said, there is a way around this problem -- more in a moment.)

Tax Returns

With most income distributions, you receive a Form 1099 to file with your taxes. Simple. With an MLP, you get a Schedule K-1, which is more complicated. And if you own an MLP with operations in a dozen states, you may need to file a return with each -- and owe an extra $1,000 or more to your tax preparer, says Jeffrey Phillips, chief investment officer at Troy, Mich.–based Rehmann Financial, which has more than $2 billion under management.

History

In short, there's not much of it. When modeling a portfolio, it's nice to have a lot of data in order to see how investments perform at different points in time. For instance, we have good data on stocks and bonds starting in the 1920s. But MLPs, for the most part, grew out of the 1986 Tax Reform Act -- and didn't really start proliferating until about a dozen years ago. As such, there's not a lot of historical data to hang your hat on.

Capital

Or the lack thereof. MLPs have to distribute most of their income to investors. That means there's little cash left over to fund growth. As such, MLPs typically turn to debt and equity markets to raise capital. Of course, access to capital all but shut down in 2008 and 2009. If we run into another credit crisis, notes Mark Willoughby, principal at Boston-based Modera Wealth Management, some MLPs could have a tough time finding money to grow their businesses. And that, in turn, could hurt the prices of these products and the growth of distributions.

Congress

Washington, meanwhile, has a deficit problem on its hands. One idea to raise revenue that has surfaced on occasion: Change the tax code to end preferential treatment of "pass-through" entities, including MLPs. Could it happen? Most observers think the chances are slim, but Canada has clamped down on similar structures.

If you wish to jump into the MLP pool, start small. Charles Farrell, CEO of Northstar Investment Advisors in Denver, cautions that too large an MLP investment can overweight a nest egg with energy and natural-resource holdings. Northstar's default portfolio (one-half stocks, one-half bonds) allocates 10 percent of equities to MLPs -- or 5 percent of the total pie.

You can, obviously, buy individual MLPs. Jason Stevens, equities analyst at Morningstar, suggests looking at Energy Transfer Partners and its general partner, Energy Transfer Equity (both of which should benefit from the latter's recent merger with Southern Union, a pipeline operator). Other prospects: Magellan Midstream Partners (annual tariff increases help boost revenues) and Enterprise Products Partners, one of the industry's biggest players, with more than 50,000 miles of pipeline.

But making an informed choice among these firms requires diving into all manner of MLP minutiae (there are "upstream," "midstream" and "downstream" plays) and being conversant in industry yardsticks. (Can you say "distribution coverage ratio"?) If that's intimidating, look at the three dozen or so funds that invest in MLPs, suggests Phillips, the CIO at Rehmann. He points to an exchange-traded fund, Alerian MLP, which holds 25 partnerships that track the industry, as a good candidate. The fund currently yields about 6.2 percent and had a total return of 10 percent for 2011, versus 17 percent for its industry benchmark.

Beyond simplifying (somewhat) your decision-making, a fund can simplify your paperwork. That's because a fund, at tax time, generates a 1099 and not a K-1. What's more, an MLP fund, given its structure and how it pays out distributions, can be held in an IRA. One potential hitch: A fund's fees could reduce the return you might otherwise get with individual MLPs.

Your best bet: Before investing a dime, check out the free "Wells Fargo MLP Primer: Everything You Wanted to Know About MLPs But Were Afraid to Ask," at naptp.org. (Click on PTP 101, then Presentations and Primers.) And remember: If you think you can't get burned with MLPs -- or with most income-producing investments -- you have no business owning them.

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